Reality Check
Most Americans delay thinking about how much income they actually will have in retirement—and how to budget during those years accordingly. In fact, a recent Transamerica Center for Retirement Studies survey found that only 15% of people have a written retirement income plan. However, thinking about income in retirement is critical because, for most people, it will change over the course of their golden years.
“Participants don’t really start thinking about it until they are 55 or 60 years old—and really toward 60,” says John Ludwig, founder of LHD Retirement in Indianapolis. “Everybody is waiting to engage because of one thing: They’re afraid. They’re afraid because they know, in the back of their minds, that they didn’t save enough. They think, ‘I don’t want to know how bad it is.’ So, subconsciously, they try to avoid the pain of knowing. But at the end of the day, they are better off knowing and having the chance to do something about it.”
Participants nearing retirement can help themselves by planning realistically for their retirement spending and account drawdown, he says.
‘Go-Go’ to ‘No-Go’
Spending varies based on someone’s stage of retirement. “Recent
retirees are in a ‘go-go’ mode, and their expenses actually may increase,” says
adviser Steven Kaye, CEO and founder of AEPG Wealth Strategies in Warren, New
Jersey. “By mid-retirement, people are in a ‘slow-go’ mode, and their expenses
may not increase. And later in retirement, people are in a ‘no-go’ mode, and
their expenses increase again, largely because of health care.”
“In your early years of retirement, you are more active and healthy,” says Joseph Ready, executive vice president at Wells Fargo Institutional Retirement and Trust in Charlotte, North Carolina. “You do things such as travel, and your spending on discretionary expenses may be higher than before you retired.”
For today’s retirees, spending often hits its peak during their first three to five years post-employment, Ludwig says. “People go on a spending binge,” he says. “They are not going to work, so they need something to occupy their time. They sit and think about the things they could do, and then they go out and spend money on them.”
Interestingly, research reveals that “social spending” plays a vital role in retirement satisfaction, says Michael Finke, dean and chief academic officer at The American College of Financial Services in Bryn Mawr, Pennsylvania. These expense categories typically include some social element, such as dining out and traveling.
“Research finds that people who spend more on those categories are significantly happier in retirement,” he says.
What percentage of pre-retirement income people need for retirement expenses also varies according to their employment income level. Finke worked on a study that examined expenses both before and after retirement among the top 20% of American earners. “What surprised us is that, in retirement, they tend to spend only about 40% of the income [they had] before they retired,” Finke says.
But middle- and lower-income retirees generally spend a much higher percentage of their pre-retirement income, Finke says. However, Social Security also replaces a larger percentage of their income so they need less in their 401(k) account, he notes. “The key is that you need to replace what you were buying before, the lifestyle you had before retirement.”
Some spending tends to go down in early retirement, across income levels, Finke says. “You pay less in taxes, you are not saving for retirement anymore, and very often people have paid off their mortgage,” he says.
On the flip side, Kaye says, early-stage retirees actually may need more in emergency funds. “It’s not just emergency funds for you. People need to consider: ‘Who might be a financial imposition on me?’” he says. “Be realistic: If you have a child who just graduated from college and started his first job, do not expect that he will never be unemployed and need your help.”
Today, more than ever, people who retire are in a “squeeze generation,” Ludwig points out. “They have parents in their late 70s or 80s, and they also have kids who still need their financial support,” he says. “Maybe their parents did not save enough, and these retirees are trying to help them at the same time that they’re trying to help their kids. We’re living in a time when kids are not leaving home as early: More of them now say, ‘I’ll just live in my parents’ basement.’”
Then, later in retirement, discretionary expenses drop as retirees have more of a sedate lifestyle. “As we get older, we do not have the same capacity to do stuff, or want to do as much stuff,” Ludwig says.
While some expenses decline later in retirement, others often increase. “As you get older, your discretionary spending may slow down, but your health care expenses pick up,” Ready says. “People start facing expenses such as for an assisted-living facility. That’s the scary part [of late-retirement expenses] for people.”
Because of all the unknowns about future health, it is difficult to project a specific person’s retirement health-care costs, Kaye says. “But increasingly, as retirees, we all have to reach into our pockets more and more: Every year, the co-pays and deductibles increase, and the limits for procedures are shrinking and being capped,” he says. “When we do retirement-income planning for clients, we use a projected annual inflation rate of 7% or more for health care.”
Health care expenses are the toughest thing to pin down when budgeting for later retirement years, says adviser Thom Shumosic, founder of MidAtlantic Retirement Planning Specialists in Wilmington, Delaware. “The big question is, what happens in the last 10 years of your life? Will you need to have a nurse come into your home? Will you need to go into a nursing facility?” he says. “If you have a whole bunch of money, you will be in great shape. If you have no money, you’ll be taken care of [by government support]. It’s the vast majority of people in the middle who will have a problem.”
The Brass Tacks
Given all the budgeting realities, advisers working with
pre-retirees need to help them understand at what rate to draw down their
money. “You are going to end up with a pile of money, and you will have to
figure out how to distribute it,” Shumosic says. “Sometimes we meet with
participants who say, ‘I am just going to take out 10% a year.’ That’s a
formula for failure. One of the biggest risks that people have, going into
retirement, is they will get to age 88 or 90 and run out of money.” In fact,
51% of people fear they will outlive their savings, according to the
aforementioned Transamerica Center for Retirement Studies survey.
When contemplating the right pace for a retiree’s account withdrawals, the old ground rule of 4% a year could help but just as a starting point, according to Colleen Jaconetti, senior investment analyst at the Vanguard Investment Strategy Group in Malvern, Pennsylvania. The 4% rule has assumptions built into it that may prove right or wrong for a particular retiree’s experience—assumptions related to factors such as expected lifespan and consistently smooth market returns. “Say that I retire at age 60. I could easily live until 95 or 100,” she says. “And you could have very good market returns or very poor market returns in retirement. The 4% rule doesn’t take that into account.”
Vanguard looked at a less-static method for retirement-phase spending and withdrawals in its 2013 paper “A More Dynamic Approach to Spending for Investors in Retirement.” That approach establishes a “floor” and “ceiling” percentage that a retiree could withdraw from his portfolio annually. He then calculates his available spending amount for a year as a percentage of the portfolio’s value, based on market results for that year. “If the newly calculated spending amount exceeds the ceiling, the spending amount will be limited to the ceiling amount,” Jaconetti says. “If the calculated spending falls below the floor, the spending amount is increased to the floor amount.”
To pull off that variable-withdrawal approach, it helps for retirees to keep their fixed expenses low, so they can budget for taking less money from their account when the market has declined, Jaconetti says. “If you decide you want $50,000 a year to spend in retirement, and $40,000 or $45,000 of that is fixed expenses, you don’t have much flexibility,” she notes. So that dynamic approach can be problematic for people still paying off debts such as loans for their child’s college education. “People should try as much as possible to get those expenses paid off in their working years,” she says.
As they budget for their future expenses, participants nearing retirement need to first understand approximately how much monthly income they can expect from their retirement account as well as Social Security benefits, Ready says. “I always say that you have to get down to the brass tacks on building a budget,” he says. “The best way to do that is to start out with: ‘What are my basic needs that I have to fund?’ Things like food, housing and health care. That is your ‘floor’ amount that you need to live on. And on top of that is: ‘Do I have any discretionary-spending goals for my retirement?’ Often, people want to travel, and they want to leave money to their kids. We tell them, ‘That’s a goal. Your aspiration may be to do that, but that may not be practical. You may need to spend down that money on your living expenses.’ People need to look at: Does the math work? You have to get into that level of detail to allow yourself to retire with confidence.”
When people look at their vision for retirement, they should separate the “needs” from the “wants” when planning expenses, as Kaye says. “Realistically, that involves looking at their discretionary expenses and making choices,” he observes. For example, someone may do less traveling early in retirement than he had hoped, to have more money available for health care expenses late in life.
It does not work as well to “dig into the numbers” of budgeting for retirement in group meetings, Shumosic has found. “These things are always delivered more effectively in one-on-one meetings,” he says. “Participants want to sit down with somebody and ask questions, and get help to formulate a game plan.”
KEY TAKEAWAYS
- Few retirement plan participants have calculated how much their current savings, deferrals and portfolio will generate in retirement income.
- Participants need to realize that their income needs will fluctuate throughout their retirement years, with spending in the early years potentially being higher as they fulfill retirement dreams.
- Advisers can encourage participants to begin any analysis or budget by calculating the cost of the essentials, which means that travel and leaving an inheritance may not be possible.